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Anchoring strategic asset allocations to valuations

02/02/2015

Chris Durack

Country Head of Hong Kong and Head of Institutional Asia Pacific

The key difference between objective based multi-asset investing and traditional multi-asset investing is that the objective based portfolio is not anchored to a single strategic asset allocation (SAA) based on long run assumptions. The application of a long run SAA portfolio is convenient since it provides a basis for anchoring the investment strategy and therefore also provides a performance benchmark. However, we have long argued that despite its conveniences, a long run SAA framework leads to inefficient outcomes when compared to achieving an objective of real returns.

Why? The key reason is the SAA framework fails to discount all available information. Instead of structuring a portfolio to take account of current market conditions, the SAA framework only incorporates information based on very long run averages. This is why many institutional portfolio changes are minimal even in the face of quite dramatic changes in valuation conditions impacting markets. This also explains why many institutional investors entered the GFC carrying very high exposures to equity markets.

Up until now, we have been aware that while many investors have recognised the shortcomings of maintaining an SAA framework, there has been a lack of any systematic framework to stand in its place to alleviate key shortcomings.

Many investors have instead moved to apply enhancement concepts such as “Dynamic Asset Allocation” (DAA), a process in which medium term asset allocation tilts are applied to portfolios thereby moving them away from the long run SAA portfolio when valuation (or other factors) moves to extremes relative to the long term average.

While some applications of DAA practices will no doubt prove more successful compared to adopting a passive SAA portfolio, others may not. Whatever the case, the one central issue that cannot be resolved by adopting such an approach is the central anchoring bias to the long run average portfolio.

It is for this reason that we prefer to address the central problem of anchoring bias to an SAA at its root cause. That is, to recognise that over medium term periods, market returns are conditional on fundamental factors which evolve. A key question is whether such fundamental factors are structurally identifiable. If they are, then they can be incorporated into a long term asset allocation framework and remove the bias to a single SAA portfolio.

In this paper[1], we test for the reliability of valuation as an indicator of future market returns over a long range of data and find strong favourable evidence. We also test explicit rules for structuring valuation factors that can guide a change in strategic asset allocation when market conditions dictate. We argue that because conditional rules can be identified and incorporated explicitly into a multi-asset framework, then such analysis can be used to augment single portfolio SAA frameworks and break down the bias towards one long term portfolio, without having to rely on the opacity and subjectivity of any single manager’s approach.

[1] In conducting this research, Schroders contracted independent actuarial firm Rice Warner, to provide modelling input on both an historical and prospective basis. We are grateful for their contribution to this work.

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